Startup funding by resident angel investors is under the scanner of finance ministry. If the amendments to the section 56(2) of Income Tax Act are to go by, all funding by non-VC registered entity above the fair market value of the share price will be treated as “Income from other sources” and taxed.
This would essentially kill most of the angel funding happening in India since such deals happen at share prices which is above fair market value. The proposed changes will come into effect from April 1, 2012 unless the finance ministry makes the provision applied retrospective from an earlier date. Venture Capital funds which are registered in the country are exempt from this provision. Given that most early stage funding is done by Angel groups or wealthy individuals who are not registered as a VC fund, this provision is bound to create further difficulties for a startup.
Government’s rationale in bringing this change is to curb illicit money entering the system through investment in early stage companies. While there may be some truth in that argument, however, to punish the entire startup community for this seems rather harsh and unwarranted. At this stage, what India needs is more innovation and SME growth which can only come if there is a favourable startup ecosystem in the country. Angel investors and funding is a critical part of that ecosystem.
As a startup founder there are a few ways to avoid this provision. These include forming an LLP instead of a Private Company, taking investments from a foreign angel or venture capital fund or to accept convertible debt into the company. While all these alternatives have their pros and cons, it is not clear whether the Government may move to include LLPs and Partnerships under the provision.